The market will correct 6-8 per cent from current levels, according to the global financial services major.
"The stock markets will be range-bound in the 18,500-20,500 range as weak economic and earnings growth caps the upside while hopes of rate cuts and policy measures protect the downside," BofA-ML said in the report dated September 23.
Stocks, which rallied sharply since Raghuram Rajan took over as Reserve Bank of India Governor on September 4, have fallen sharply since the central bank's policy review on September 20.
The benchmark 30-share S&P BSE Sensex, which lost 745.68 points in the previous two sessions, today fell by as much as 118.18 points, or 0.59 per cent, to 19,782.78 in the morning.
The Sensex had surged 685 points to close at an almost three-year high of 20,646.64 on the eve of the RBI policy review. The index gained 9 per cent between Raghuram Rajan's takeover and the policy review.
The report noted that "as markets are already close to our upper limit of the 'range' we believe the risk reward is not favourable."
According to BofA-ML, one key risk for the markets is that foreign institutional investor (FIIs) holdings, at about 21 per cent, are close to all-time highs.
"India thus remains vulnerable to any global emerging market sell-off in the near term," BofA-ML said.
Moreover, sentiment towards the Indian markets has turned negative and this could likely impact FIIs inflows if things worsen in the coming months.
Other factors that may affect the market trend include earnings recovery, the RBI's main focus on inflation, forthcoming elections, negative sentiment about India and high valuations.
On earnings, the report said given the delay in macro recovery and demand destruction, BofA-ML does not expect a material pick-up in corporate earnings.